Leases: Ghost Leverage Exposed

Lease structures matter more than ever when the rest of the margin equation gets stressed. This is when the aggressive models are exposed, and the conservative models are rewarded.

Those who have been tracking my analysis know that I’m pretty much obsessed with operating lease structures for retailers. Not out of morbid curiosity, but by the way that striking such agreements as it relates to duration, and varying step-up factors can meaningfully distort current earnings streams. Here are two Exhibits showing two overriding themes. 1) Minimum lease obligations over 5 years versus current operating margins, and 2) The incremental change in that rate over the past 2 years. Some interesting conclusions…

LEASE PORTFOLIO
1) Those with the healthiest lease obligation ratio include Timberland, Warnaco, Philips-Van Heusen, Columbia, Payless, Hibbett, Carter’s Nike and VF Corp. These are companies that have a call option to alter lease terms (i.e. lower near-term payments, but higher escalators, or for example), and improve operating margins. Whether or not this strategy is wise, it is an option.

2) The companies with the poorest positioning are Dick’s, DSW, Skechers, and BJ’s. I’d even highlight Coach and Abercrombie as high margin, low flexibility portfolios. That’s not to say that there is massive risk to those models, but simply that if business slows meaningfully, their respective options are more limited to tweak the portfolio to ease a margin pinch.

CHANGE IN PORTFOLIO
1) In looking at the incremental change in ‘flexibility ratio’ over the past 2 years, there are some clear standouts. Timberland, Finish Line, Columbia, Ralph Lauren, Van Heusen, Warnaco, and Hibbett all look particularly good, with improvements of 10 points or more.

2) On the flip side, Skechers, Quiksilver, Carter’s, VF Corp, Nike, and to a lesser extent Abercrombie all register at the opposite end of the spectrum. These companies have been taking up forward minimum obligations relative to current payments. This is not always bad, as it might be explained away by a change in business mix (i.e. JNY’s got worse bc it divested Barney’s). But overall, it is a way for a company to boost current margin run-rate, and is a key factor to watch.

NET/NET
Positive Standouts: Timberland, Columbia, Ralph Lauren, Phillips-Van Heusen, and Hibbett.

Negative Standouts: Skechers, Dick’s, DSW, Carter’s VF Corp and Nike.

Click on charts below for a larger view, or email me for the Excel file.

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